GOLDMAN: We Expect The Fed To Make A Key Change To Offset The Impact Of The Taper

REUTERS/Jim YoungU.S. Chairman of the Federal Reserve Ben Bernanke listens to questions as he testifies before a House Budget Committee hearing on "The Near-Term Outlook for the U.S. Economy" on Capitol Hill in Washington, January 17, 2008.

The consensus view on Wall Street is that the Federal Reserve will begin to scale back its open-ended quantitative easing program at its September 18-19 FOMC meeting on monetary policy.

Under the program, the Fed buys $85 billion of Treasuries and mortgage-backed securities every month. Primary dealers expect the Fed to announce a reduction in the pace of purchases to $65 billion a month in September.

Goldman Sachs chief economist Jan Hatzius is one of those who expects tapering to begin at the conclusion of the September meeting.

This prospect has caused a sharp rise in volatility in the U.S. Treasury market over the past three months as investors price in the tapering possibility, but Hatzius argues the Fed will take steps to offset the negative effects of tapering on markets by tweaking its other main policy instrument: guidance on the future path of the fed funds rate, which is currently pinned near zero.

The Fed has said that before it will consider raising the fed funds rate, the unemployment rate must fall below 6.5% and inflation must reach 2.5%.

Both thresholds are a ways off, but Hatzius says the Fed may tweak them slightly at one of the next two meetings to lend credence to the message that low rates is the status quo for a while yet, in the process hopefully curbing any tapering-induced market volatility.

In a note, Hatzius writes:

We still expect Fed officials to taper QE at the September 17-18 FOMC meeting, but to offset the impact on financial conditions by reinforcing the forward guidance for the funds rate. There are two broad possibilities for how this might happen. First, they could simply lower the 6.5% unemployment threshold. Second, they could make the unemployment threshold depend on inflation and/or labor force participation; thus, inflation below 2% or a further decline in participation would imply a threshold of less than 6.5%. We interpret the fact that the FOMC this week “reaffirmed its view” that policy would need to stay highly accommodative even after the end of QE3 as a hint that the guidance will indeed be strengthened further.

The FOMC statement did not signal explicitly that this shift in the “mix of instruments” will occur in September, and a later move is possible. But Chairman Bernanke’s various appearances over the past few weeks have prepared the ground for such a shift, and the market seems to have digested it. The Fed leadership transition also argues for September rather than December, as it creates an incentive to make the December meeting—which is likely to be close to the confirmation hearings for the new Fed chair—less rather than more eventful.

Chicago Fed President Charles Evans, after which the "Evans Rule" is named, speaks with reporters in Chicago at 1 PM ET. In a week light on economic data releases, those market participants not on vacation this week will likely be listening closely for any additional clues surrounding the tapering timeline.